The Sustainability of Korea's Trade Balances with China and Japan: Perspective from the Asymmetry in Income Elasticities

This analysis of the trade balance has been inspired by the Houthakker and Magee finding, namely that the income elasticity of export (import) exceeds that of import (export). However, it is known that estimates of the income elasticity of demand are substantially biased due to the omission of supply capacity terms such as trade variety or FDI. Many previous studies have used a proxy for the varieties of goods in import demand in order to correct the bias that arises from ignoring product proliferation. This paper uses an import demand equation that incorporates the direct measures of trade variety that are consistent with an underlying constant-elasticity of substitution aggregator function in order to estimate unbiased income elasticities for Korea��s trade flows with China and Japan. This paper shows that the income elasticities for export and imports are quite high from the standard import demand equation, and the inclusion of terms such as trade variety and FDI reduce the magnitude of the income elasticity. However, the asymmetry in the income elasticities of export and import in the Houthakker and Magee finding persists for Korea��s trade flows with China and Japan. Given that the new elasticities predict ��better��, the trade surplus in Korea��s trade with China is to be small, and deficit with Japan is to be large.